How to Use the P/B Ratio

The price-to-book (P/B) ratio is widely associated with value investing, and in fact we use it as one of the metrics on our Motley Fool Inside Value scorecard. Like the price-to-earnings (P/E) ratio, a low P/B ratio isn't always indicative of an undervalued company. Conversely, companies with a relatively high P/B ratio are not necessarily overvalued. P/B is a useful measure for comparing firms that have negative earning; those businesses can't be compared using the P/E ratio. Quite simply, far fewer firms have negative book values.

The P/B ratio is calculated as follows:

P/B ratio = market capitalization / book value of equity(Market capitalization is often abbreviated as "market cap"; book value is often abbreviated as "BV")

Market capitalization = shares outstanding * market price per share

Book value of equity = book value of assets - book value of liabilities

So therefore, P/B = market cap / (BV of assets - BV of liabilities)

The book values of assets and liabilities are easily found on the balance sheet. The book value of assets is usually classified as "total assets." You may need to do some arithmetic to arrive at the book value of liabilities (it may not be quite so obvious on some balance sheets), but it includes all current liabilities and long-term obligations. The book value of equity is often broken out for us under the heading "Shareholders or Shareowners Equity." In my experience, most financial websites are fairly accurate with P/B ratios.

What we can deduce from a low P/BIn absolute terms, a P/B ratio under 1.0 is considered low (there are some variations that I'll explain later). Generally speaking, a low P/B can indicate:

That assets are overstated on the balance sheet. In this case, we should avoid the company because it may be destroying shareholder value. Ford (NYSE: F) is a good example of this. According to MSN Money Central, Ford's P/B was 0.72 in 1997, and its book value per share was $25.54. Today, Ford's P/B is 1.30, and its book value per share is down to $7.66. During that time, the share price has fallen from nearly $50 to less than $10. Clearly, Ford had other problems, but the low P/B certainly did not indicate value. At Inside Value, we generally look for companies that have been increasing book-value-per-share over a number of years because -- as Ford's plight shows -- the share price often follows the book value per share.

That the company will generally have a poor return on equity (ROE) and poor return on assets (ROA). If earnings are negative, there will be a negative ROE and ROA. Of course, if there is a solid management team that is turning around the company's fortunes, then we may have an interesting value proposition. When I first recommended MCI for Inside Value subscribers, it certainly fit that mold.

That the industry at large has a low P/B. Certain industries have low P/B ratios, generally because they are cyclical or because the companies generate relatively low ROE. Hurricane Katrina reminds us that insurance companies typically have low P/B ratios because of the cyclicality of that industry. "Hard insurance markets" (i.e., those with higher premiums) form after a major disaster. This attracts new capital in the short term, when investment returns can be very good. After a while, however, competition increases and the market softens. It's important to find insurance companies that maintain discipline in a soft market. Otherwise, they'll take on risks that are not adequately covered in the premiums. Eventually, claims will roll in, along with underwriting losses, and the book value will be reduced.

P/B has a buddyROE is a useful companion metric for P/B. This is no surprise; after all, the "B" in P/B and the "E" in ROE are one and the same -- they're both symbols for book value of equity.

A high ROE normally accompanies a high P/B ratio because investors naturally bid up the price of a company that gives them a better return on their equity. Similarly, companies that have high earnings growth rates generally have high P/B ratios -- investors expect the book value of equity per share to grow.

However, if a high-growth company has a high P/B ratio and low ROE, that growth may not be translating into shareholder value. This could portend a collapse in share price.

Even if growth rates are average, a company with a high ROE will generally have a high P/B ratio. Consequently, I always screen for ROE and P/B. The difference between the company's ROE and its cost of capital is important. The wider the spread, the higher the P/B ratio (the higher it should be, at least). Even when comparing P/B within an industry, there may be discrepancies that have nothing to do with valuation.

Best use of P/BP/B is best used for asset-heavy companies, such as financial institutions, manufacturing companies, and other capital-intensive industries. Companies with a regular inflow of new assets, such as capital expenditures in the case of DaimlerChrysler (NYSE: DCX) or more cash in the case of JPMorganChase (NYSE: JPM) , are likely to have book values that at least relate to market values (e.g., at around 1.2 for the P/Bs of Daimler Chrysler and JPMorgan). In both cases, a lower-than-average P/B ratio compared with past years may indicate a value opportunity. Comparing it to the S&P 500 average P/B of 2.84 (according to Barra) is meaningless as a measure of value.

P/B distortionsDistortions in P/B (and ROE, for that matter) arise because book value of equity is more an accounting measure than an economic measure. Here are a few natural distortions to watch out for:

Companies that have very long-lived assets (like real estate) still on the balance sheet at original cost (i.e., the book value) will have understated assets and, therefore, an understated book value (remember, book value of equity = assets - liabilities). All other things equal, the effect will be an increase in the P/B ratio, as the reported "B" is lower than the real value of the equity. In this case, you might miss an undervalued company by simply looking for low P/B ratios.

Service companies, and those that rely on intellectual property (IP), are not capital-intensive, and they do not have significant assets recorded on the balance sheet. A good example is Microsoft (Nasdaq: MSFT) . At the end of its 2004 financial year, Microsoft had $94 billion in assets, with a full $60.6 billion in cash and equivalents, $10 billion in other current assets, and only $22 billion in longer-term assets. Nearly all Microsoft's IP was developed in-house and is not capitalized on the balance sheet -- and it can't be, because IP must be expensed on the income statement under U.S. generally accepted accounting principle rules.

Recent acquisitions will generally increase the book value and lower the P/B because the new assets go on the balance sheet at the full price paid. In the unlikely event that Microsoft acquired Oracle (Nasdaq: ORCL) and all of its IP for $70 billion in shares, the full $70 billion would be recorded on the balance sheet as an asset. The amount in excess of Oracle's $11 billion book value ($59 = $70 - $11) would show as goodwill.

A serial acquirer of other companies will almost always have a high book value, which may artificially lower P/B. However, a huge part of the book value will be in goodwill or intangibles. In this case it is prudent to subtract goodwill from book value, resulting in a "tangible book value." We can then calculate the more meaningful "price-to-tangible-BV ratio."

Recent write-offs will reduce the book value of equity. Companies typically say that this is a non-cash charge, yet in a real sense it reduces the value of shareholder equity. It may not show up in the P/B ratio because as companies reduce the "B" via write-offs, investors reduce the "P" via a lower stock price.

A company that has a history of buying back a large number of shares (in excess of covering dilution from employee stock options) will have a lower book value. All of the shares bought back go into what is called "treasury stock" at the full buyback price, and these are subtracted from book value. The original shares are recorded at par value, which is usually as low as $0.10 to $1.00 per share. A good example is Inside Value newsletter pick Anheuser-Busch (NYSE: BUD) , which in the past four and a half years bought back 140 million (15%) of its shares. Book value is just $3 billion, yet the company has almost $15 billion in treasury shares. Without any buybacks the book value would be around $18 billion. A really good indicator here is that both the P/B and the ROE will be extraordinarily high. For Anheuser-Busch, P/B is 11.7 and ROE is 75, which are extraordinarily high and of little use in assessing the value of the company. To overcome this, we can use a BV adjusted for share buybacks. This would reduce the P/B to 2.0 and the ROE to around 13.

Foolish final thoughtsThat's just a brief look at the P/B ratio, and I've only touched on a few of the wrinkles associated with it. P/B is a very useful measure of value, but as with other valuation metrics, it should not be used in isolation.

Philip Durell heads up the Fool's Inside Value newsletter service. To date, his picks are outperforming the S&P 500 by a margin of 4.43% to 0.20%. If you'd like to join Philip on the search for undervalued stock opportunities, you can sample his service for 30 days for free. There is no obligation to subscribe.

Philip Durell does not own shares of any company mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor recommendation. The Motley Fool has adisclosure policy.

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